SEC Takes Shot At Defining VC; Now Industry Gets Its Say

The venture industry appeared to nudge closer to being mostly exempted from onerous new reporting requirements loaded on to their private equity brethren, as the Securities and Exchange Commission has proposed new definitions for venture funds that would seem to capture most of the industry.

But the industry is taking a closer look before it pops the champagne corks.

- Only invests in equity securities of private operating companies to provide primarily operating or business expansion capital (not to buy out other investors), U.S. Treasury securities with a remaining maturity of 60 days or less, or cash.

- Is not leveraged and its portfolio companies may not borrow in connection with the fund’s investment.

- Offers to provide a significant degree of managerial assistance, or controls its portfolio companies.

- Does not offer redemption rights to its investors.

A key part of the proposed new rules is a grandfather clause that essentially make all existing funds exempt, meaning only new funds would have to meet the new requirements. The commission also is proposing an exemption for private funds with less than $150 million in assets under management in the U.S.

Under the proposal, VC firms would still be required to file reports with the SEC, but they’d only have to fill out a limited amount of information, including basic information on the firm’s personnel and affiliates, potential conflicts of interest and any disciplinary history of the fund adviser and employees “that may reflect on their integrity.”

How much oversight or policing the SEC would do if the new rules were to be enacted remains to be seen; the definitions seem vague enough (what, exactly, is a “significant” degree of managerial assistance?) and reliant enough on self-reporting (such as the rule that a firm is exempt if it “represents” itself as a VC fund) that it’s a bit too early too tell whether this is a true win for VC firms.

“These parameters are all very consistent with the messages NVCA has conveyed to SEC staff and commissioners about the industry in recent weeks,” read a blog post on the National Venture Capital Association blog. “We are awaiting details of the proposal and will be better able to share a complete reaction once we have that information.”

The SEC is opening a 45-day public comment period, so chances are we’ll be hearing a lot more about how VCs really feel.

Comments (1 of 1)

The Dodd-Frank Act has precipitated yet another hapless regulatory attempt at defining venture capital. I say hapless because venture capital investing is not a static concept, which make any attempt to capture its nature in a definition questionable.

This said, I believe that the SEC's proposed definition is off base in at least two important respects: the notions that leverage is not a fundamental part of the venture capital experience and that avoiding leverage is necessary to minimize so-called "systemic risk." This attitude toward leverage is incorporated in two central elements in the proposed definition: First, that a venture capital fund may not lend to its portfolio companies, and second, that portfolio companies, in order to be "qualifying," may not incur leverage in connection with the receipt of venture capital funding.

In my over 40 years as a lawyer representing venture capital funds and venture-backed companies, I can't think of one such fund that did not, at one time or another, provide bridge loans to portfolio companies. I note that this type of lending is essential to the operation of a fund that backs nascent and growing businesses where cash-flows are usually negative to uneven and the business models are unproven. Further, based on this experience it is evident that venture capital funds often provide equity capital to portfolio companies coincident with, and in some cases conditioned upon, the companies borrowing from one or more commercial sources, such as banks, commercial lenders and equipment vendors. In some instances, venture capital funds may even guarantee the repayment of borrowings of this type.

I cannot see how this leverage could contribute to the systemic risk of United States financial institutions for two reasons. In the first place, venture capital funds seldom borrow themselves because the arrangements with their investors severely restrict borrowing (such as to permit short-term borrowings of no more than 10% of committed capital). Thus, if a venture capital fund were to incur heavy losses on its investment portfolio, these losses would not be magnified by leverage and could not imperil its investors beyond their investment in and express financial commitments to the fund. Parenthetically, it is almost self-evident that investors in these funds do not leverage their fund investments.

By the same token, borrowing by venture-backed companies can only contribute to systemic risk if their lenders act imprudently. The means of addressing lender imprudence can only be effectively taken by bank and financial institution regulators because only they have the experience and perspective to perform this function. It makes no sense whatsoever for the SEC to attempt to mitigate the risk posed bank or commercial lending to venture-backed portfolio companies through its regulation of registered investment advisers.

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